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Lecture 7 - Working Capital Management

Assistant Professor Ronaldo C. Reyes

I. Working Capital Management is the administration and control of the company's working capital.
The primary objective is to achieve a balance between return (profitability) and risk.

Financial Analysts Viewpoint Accountants Viewpoint


Working capital equals current assets Working capital equals current assets minus
current liabilities
Current Assets are those assets that are Current Assets are composed of :
reasonably expected to be realized in cash or Temporary Current Assets - current assets, such
consumed or sold during the normal operating as cash, that fluctuate with the firm's operational
cycle of the business. These include cash, needs. Example are inventory buffers.
marketable securities, receivables, and inventory
Permanent Current Assets - the portion of the
company's current assets required to maintain the
firm's daily operations. It is the minimum level of
current assets required if the firm is to continue its
operations
Current Liabilities - their liquidation requires the use Spontaneous Liabilities – liabilities that are
of current assets or incurrence of other current automatic in the conduct of the company’s
liabilities are liquidated within 1 year. operation and does not normally require
management approval to incur
Non Current Liabilities – are liabilities that have Long-term Liabilities - are liabilities that have
maturity of more than 1 year. maturity of more than 1 year.

II. Major Concerns in Working Capital Management:


1. Business trends/cycles.
a. Secular
b. Cyclical
c. Combination
2.. Hedging should be observe : match the financing assets with liabilities of similar maturity.
3. Peso earner companies should not borrow foreign currencies to avoid exposure to foreign exchange
risks.
4. The composition of working capital.

III. Working Capital Financing Policies


1. Conservative (Relaxed) Policy - operations are conducted with too much working capital; involves
financing almost all asset investments with long-term funds and use short term financing only for
emergencies.
Advantages
• reduces risk of illiquidity.
• Eliminates the firm's exposure to fluctuating loan rates and potential unavailability of short-
term credit..
Disadvantages
• less profitable because of higher financing costs as the company pays interest on unneeded
funds.

2. Aggressive (Restricted) Policy - operations are conducted on a minimum amount of working capital
uses short-term liabilities to finance, not only temporary, but also part or all of the permanent current
asset requirement.
Advantage
• increase return on equity (profitability) by taking advantage of the differential spread between
long-term and short-term debt.
Disadvantage
• exposure to risk arising from low working capital position.
• puts too much pressure on the firm's short-term borrowing capacity so that it may have
difficulty in satisfying unexpected needs for funds.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes

3. Matching Policy (also called self-liquidating policy or hedging policy) - matching the maturity of a
financing source with specific financing needs.
• short-term assets are financed with short-term liabilities.
• long-term assets are funded by long-term financing sources.

4. Balanced Policy - balances the trade off between risk and profitability in a manner consistent with
its attitude toward bearing risk.

IV. DECIDING ON AN APPROPRIATE WORKING CAPITAL POLICY


The amount of net working capital that a company should have depends on the amount of risk it is
willing to take. The primary consideration therefore is the trade-off between returns (profitability) and
risk (risks of illiquidity) associated with:
1. Asset Mix Decision - appropriate mix of current and non-current assets.
2. Financing Mix Decision - appropriate mix of short-term and long-term liabilities to finance
current assets.

V. Risk Return Trade-off


1. The greater the risk, the greater is the potential for larger returns.
2. More current assets lead to greater liquidity but yield lower returns (profit).
3. Fixed assets earn greater returns than current assets.
4. Long-term financing has less liquidity risk than short-term debt, but has a higher explicit cost,
hence, lower return.

VI. Forecasting

Percentage of sales forecasting method is a simple but practical procedure for forecasting financial
statement variables. The procedures are based o to assumptions: (a) that all variables are tied directly
with sales; and, (b) that the current levels of most balance sheet items are optimal for the current sales
level.
Steps;
1. Identify assets and liabilities that will vary spontaneously with sales.
2. Estimate the amount of net income that will be retained.
3. Compute the amount of External Financing Needed (EFN) by subtracting increase in
spontaneous liabilities and income retained from increase in total financing required (increase in assets
due to increase in sales.)

EFN= SΔ p x (SA/S0 ) - ΔS x (SL/S0 ) – (ROS x Payout% x S1 )


Where: SA/S = percentage relationship of spontaneous assets(variable assets) to sales at period 0.
SL/S = percentage relationship of spontaneous liabilities (variable liabilities) to sales at period 0

VI. Management of Current Assets


Objective: Determination of the appropriate mix of the current assets components (cash, marketable
securities, accounts receivables, and inventories), considering safety and liquidity, as well as
profitability.

1. Cash Management

Objective: Optimum amount of cash, (not excessive nor deficient) at the right time.
Excess cash should be invested for a return while retaining sufficient liquidity.

Thrust of Cash Management: accelerate cash receipts and delay cash payments.

Motives for Holding Cash and Near-Cash Balances;


 Transaction Motive – Cash balance is maintained in order to pay planned expenditures.
 Precautionary or Safety Motive – Balanced are held or temporarily invested in liquid securities that
can be immediately transferred to cash. This balanced protects the firm against being unable to
pay unexpected expenditures
 Speculative Motive – The balance, oftentimes kept in marketable securities, is intended for taking
advantage of opportunities that may arise.
 Compensating balance – deposit held by the bank to compensate for services provided; the
amount to be maintained for bank relationship.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes

The least amount of cash a firm should hold is the greater of compensating balance or precautionary
balance plus transaction balance.

The amount of cash to be held depends on the following factors:


1. Cash management policies
2. Current liquidity position
3. Management’s liquidity risk preferences
4. Schedule of debt maturity
5. The firm’s ability to borrow
6. Projection of short-term and long-term cash flows
7. Probabilities of different cash flows under varying circumstances.

Operating Cycle. The amount of time elapses from the point when the firm inputs materials and labor into
the production process to the point when cash is collected from the sale of the finished goods. This
consists of two components – average age of inventory and the average collection period receivables.

Cash Conversation Cycle. Total number of days in operating cycle less average payment period for
materials.

Useful Formulas
Inventory Receivables Payable
Cash Conversion Cycle = Conversion Cycle + Collection Period – Deferral Period
Or or or
Average Age + Average Age – Average Age
Of Inventories of Receivables of Payables

Inventory Conversion Number of Days in a year Average Inventory


Period or Average Age = or
Of Inventories Inventory Turnover* Average CGS per day

Cost of Goods Sold (CGS)


*Inventory Turnover =
Average Inventory

Receivables Collection Number of days in a year Average A/R


Period or Average Age = or
Of Receivables Accounts Receivable Turnover* Average Sales per day

Net Credit Sales


*Accounts Receivable Turnover =
Average Accounts Receivable (A/R)

Payable Deferral Number of days in a year Average A/P


Period or Average Age = or
Of Payables` Accounts Payable Turnover* Average Purchases per day

Net Credit Purchases


*Accounts Payable Turnover =
Average Accounts payable (A/P)

Improving Cash Conversation Cycle:


 Turnover inventory as quickly as possible, avoiding stock outs that might result in a loss of sale.
 Collect accounts receivable as quickly as possible.
 Acceleration of cash receipts
To accelerate cash receipts, one must know
 The bank’s policy regarding find availability
 The source and location of the company’s receipts
 How to devise procedures for quick deposits of checks received and quick transfer of
receipts to the main account.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes

 Pay accounts payable as late as possible without damaging the firm’s credit rating, but take
advantage of any favorable ash discounts.

Cash Management Techniques


1. Float. Funds that have been tendered or dispatched by a payer but are not yet in a form that can
be spent by the payee. Float my either be collection float or disbursement float. Net float is the
difference between the two types of float.

Components of Float;
 Mail float – The delay between the time when a payer mails a payment and the time when
the payee receives it.
 Processing Float. The delay between the receipt of a check and its deposit I the firm’s
account.
 Clearing Float. The delay between the deposit of a check by the payee and the actual
availability of the funds.

Speeding up Collections
 Concentration banking. A scheme where a firm with numerous sales outlets designated
certain offices as collection center for a given geographic areas. These collection centers
deposit the receipts in local banks; in turn, these local banks transfer the funds by the wire to
a concentration or disturbing bank.
 Lock boxes. Instead of mailing payment to a collection center, the payer sends it to a post
office box that is emptied by the firm’s bank several times daily. The bank deposits the
checks in the firm’s account and sends to the collecting firm a deposit slip or computer
printout indicating the payments received.
 Direct sends. Firms that have been received large checks drawn on distant banks or a large
number of checks drawn on banks in a given city may arrange to present those checks
directly for payment to the bank on which they are drawn.

Slowing Down disbursements


 Controlled Disbursing. Involves the strategic use of mailing points and bank accounts to
lengthen mail float, respectively.
 Use credit cards
 Playing the float
a. writing checks against funds that are not currently in the checking accounts
b. staggered funding
c. payable through draft

2. Marketable Securities Management

Objective:Determine the amount to be invested in marketable securities and when to convert the same to
cash

Thrust of Marketable Securities Management: Balance the conversion costs and opportunity costs in
converting marketable securities.

Economic Conversation Quantity (Optimal Transaction Size). Using the conversion and opportunity
costs, the model calculates the economic conversion quantity, the amount (cost-optimizing- quantity) in
which the firm should convert marketable securities to cash or cash to marketable securities.
_____________________________________
ECQ=/2x Conversion Cost x Annual Demand for cash
1/ Opportunity Cost (in decimal)

Conversion cost= the cost of converting marketable securities to cash. It includes the fixed costs of
placing an order for cash or marketable securities, paperwork costs, brokerage fees, and cost of any
follw-up action.

Opportunity Cost of Cash= (Cost per conversion x number of conversion)+ (opportunity cost x Average
cash balance)

3. Accounts Receivable Management

Objective: Formulation and administration of plans and policies related to sales on account and ensuring
the maintenance of receivables at a predetermined level and their collectibility as planned.
Thrust of Accounts Receivable Management: To have both the optimal amount of receivables
outstanding and the optimal amount of bad debts.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes

This balance requires the trade-off between:


the benefit of more credit sales, and
the costs of accounts receivable such as collection, interest, and bad debts cost

Factors in Determining Accounts Receivable Policy


1. Credit Terms - define the credit period and any discount offered for early payment.
Costs and Benefits of a Credit Extension Policy
 Cash discounts
 Credit and collection costs
 Bad debt losses
 Financing costs

2. Credit Standards - the criteria that determine which customers will be granted credit and how
much. The credit standard should not be too stringent or too tight which may eliminate the risk of
non-payment, but also eliminate potential sales to rejected customers; neither should the
standards be too loose or liberal, which may lead to higher sales, but also higher bad debt losses
and collection costs.
Factors to consider in establishing Credit Standards
 Character - a customer's willingness to pay
 Capacity - a customer's ability to generate cash flows
 Capital - a customer's financial sources such as collateral
 Conditions - current economic or business conditions.

Ways of Accelerating Collection of Receivables


1. Shorten credit terms.
2. Offer special discounts to customers who pay their accounts within a specified period.
3. Speed up the mailing time of payments from customers to the firm.
4. Minimize float, that is, reduce the time during which payments received by the firm remain
uncollected funds.

Determinants of the Size of Receivables


1. Terms of sale
2. Paying practices of customers
3. Collection policies and practices
4. Volume of credit sales
5. Credit extension policies and practices
6. Cost of capital

Aids in Analyzing Receivables


1. Ratio of receivables to net credit sales
2. Receivable turnover
3. Average collection period
4. Aging of account

Cost of Marginal Investment in Accounts Receivable

Ave. Investment in = Total Variable cost of annual sales


Turnover of accounts Receivable

Cost of Marginal Investment = Marginal Investment in AR x Required Return


On Investment In Accounts Receivable

Cost of Marginal Bad Debts= Bad debts under proposed plan- Bad debts under present plan

3. Inventory Management - formulation and administration of plans and policies to efficiently and
satisfactorily meet production and merchandising requirements and minimize costs relative to inventories.

Objective: Maintain inventory at a level that best balances the estimates of actual savings, the cost of
carrying additional inventory, and the efficiency of inventory control.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes

Inventory Management Techniques


1. Inventory Planning - determination of the quality and quantity and location of inventory, as well as
the time of ordering, in order to meet future business requirements.
EOQ Model
Reorder Point
Just-in-Time (JIT)

2. Inventory Control - regulation of inventory within predetermined level; adequate stocks should be
available to meet business requirements, but the investment in inventory should be at the
minimum.
a. Fixed Order Quantity System - an order for a fixed quantity is placed when the inventory
level reaches the reorder point.
b. Fixed Reorder Cycle System (periodic review or replacement system) - orders are made
after a review of inventory levels has been done at regular intervals.
c. Optional Replacement System
d. ABC Classification System - inventories are classified for selective control:
A items - high value items requiring highest possible control
B items - medium cost items requiring normal control
C items - low cost items requiring the simplest possible control

3. Modern Inventory Management - often applied in the context of automated manufacturing


a. Materials Requirement Planning (MRP) - designed to plan and control raw materials used
in production. The demand for materials, which is assumed to be dependent on some
factors, is programmed into a computer.
b. Manufacturing Resource Planning (MRP-II) - a closed loop system that integrates all facets
of a business, including inventories, production, sales, and cash flows.
c. Enterprise Resource Planning (ERP) - integrates the information systems of the whole
enterprise. All organizational operations are connected and the organization itself is
connected with its customers and suppliers.

Inventory Models
A basic Inventory Model exists to assist in two inventory questions:
1. How many units should be ordered?
2. When should the units be ordered?

Economic Order Quantity - the quantity to be ordered, which minimizes the sum of the ordering and
carrying costs. The total inventory cost function includes:
1.Carrying Costs (which increase with order size)
a. Storage costs c. Spoilage
b. Interest costs d. Insurance

2.Ordering Costs (which decrease with order size)


a. Transportation (delivery costs)
b. Administrative cost of purchasing and costs of receiving and inspecting goods
 Economic Order Quantity (EOQ) may be computed as follows:

Where: a = cost of placing one order (or ordering cost)


2aD D = annual demand in units
EOQ = k k = annual costs of carrying one unit in inventory for
one unit in inventory for one year

Assumptions of the EOQ Model


 Demand occurs at a constant rate throughout the year.
 Lead time on the receipt of the orders is constant.
 The entire quantity ordered is received at one time.
 The unit costs of the items ordered are constant; thus, there can be r no quantity discounts.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes

 There are no limitations oh the size of the inventory.

Note: When applied to. manufacturing operations, the EOQ formula may be used to compute the
Economic Lot Size (ELS)
Where: a = set-up cost
2aD D = annual production requirement
ELS = k k = annual costs of carrying one unit in inventory for
one unit in inventory for one year

 When the EOQ figure is available, the average inventory is computed as follows:
Average inventory = EOQ
2
Reorder Point:
When to reorder is a stock-out problem, i.e., the objective is to order at a point in time so as not
to run out of stock before receiving the inventory ordered but not so early that an excessive
quantity of safety stock is maintained. When the order point is computed, there may be a stock-
out situation if:
1. demand is greater than expected during the lead time; or
2. the order time exceeds the lead time.

Lead Time - period between the time the order is placed and received
Normal Time Usage = Normal lead time x Average usage
Safety Stock = (Maximum lead time - Normal lead time) x Average usage
REORDER POINT IF THERE IS NO SAFETY STOCK REQUIRED = Normal lead time usage
Safety stock + Normal lead time usage
REORDER POINT IF THERE IS SAFETY STOCK REQUIRED or
Maximum lead time x Average usage

VII. Financing Decisions

Short-term Financing/Short-term Credit - debt scheduled to be paid within one year.

Factors considered in selecting the source of short-term financing


1. Cost - short-term debt is less expensive.
- short-term rates are usually lower than long-term rates.
- short-term debts do not normally involve flotation or placement costs.
1. Availability of the short-term funds when needed.
2. Risk - short-term debts are riskier. Interest rates may fluctuate and more frequent debt servicing is
required.
3. Flexibility - short-term credit is usually more flexible than long-term debt. Short-term loans can be
arranged more quickly. Some lenders are more willing than others to work with the borrower,
e.g., to periodically adjust the amount when needed.
4. Restrictions - certain lenders may impose restrictions, such as requiring a minimum level of net
working capital.
5. Effect on Credit Rating - some sources of short-term credit may negatively affect the company's
credit rating.
6. Expected Money Market Conditions
7. Inflation
8. The company's profitability and liquidity positions, as well as the stability of its operations.
SOURCES OF SHORT-TERM CREDIT

I. Spontaneous Sources
A. Trade Credit / Accounts Payable — considered as a spontaneous financing because it is
automatically obtained when a firm purchases goods or services on credit from a supplier.
> It is a continuous source of financing.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes

> It is more readily available than other negotiated sources of short-term credit.
Cost of Trade Credit
Trade credit usually bears no interest, but it is not costless. Its cost is implicit in the terms
of credit agreed upon (the discount policy and the credit period).
1. No Trade Discount
Purchases on credit without trade discount are usually priced higher than cash
purchases. The difference between the selling prices is the implicit cost of credit.
2. With Trade Discount
If a supplier allows a trade discount for prompt payment, an implicit cost is incurred if
the discount is not availed of.
Example: Credit term is 2/10, "/30 - The purchaser is given 2% discount if the account
is paid within 10 days.
If the discount is not taken and the purchaser pays on the 30 th day, this means that he had 20 days
more of financing (30 days – 10 days). The cost of this additional financing is the discount foregone,
which is, in effect, a penalty or interest cost. The annual rate is computed as follows:

Interest cost per period Number of days in a year


Annual Rate = x
Usable loan amount number of days funds are used

Discount % Number of days in a year


= x
100% - Discount % net period* - discount period

* Net period or number of days the account is outstanding

Assuming 360 days in a year is used in the calculation, the annual rate in this example is:
2% 360 days
Annual Rate = x
100% - 2% 30 days – 10 days

2% 360 days
= x = 36. 73%
90% 20 days

B. Accruals (Accrued Expenses) - another form of spontaneous financing, which represent liabilities
for services that have been provided to the company but have not yet been paid for. Typical
examples are accrued wages and taxes.
COST OF ACCRUALS - None, whether implicit or explicit cost.
C. Deferred Income - customers' advance payments or deposits for goods or services that will be
delivered at some future date.
COST OF DEFERRED INCOME – None

II. Negotiated Sources


Unsecured Short-Term Credit
A. Commercial Bank Loans - short-term business credit provided by commercial banks,
requiring the borrower to sign a promissory note to acknowledge the amount of debt, maturity
and interest.
a. Line of Credit - the bank agrees to lend up to a maximum amount of credit to a firm. This is
applicable to firms that need frequent funding in varying amounts.
 Revolving credit agreement - the bank makes a formal, contractual commitment to provide
the maximum amount to a firm. The firm pays a minimal commitment fee per year on the
average unused portion of the commitment.
b. Transaction Loan (a single payment loan) - short-term credit for a specific purpose.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes

Cost of Bank Loans

a. Regular Interest Rate = Interest


Borrowed Amount

b. Discounted Interest Rate = Interest


Borrowed Amount – Interest

c. Effective Interest rate = Interest


Usable Loan Amount*
* Usable Loan Amount = Loan amount - Discount interest - Compensating balance**
** Compensating balance - a certain percentage of the face amount of the loan that
must be maintained by a borrower on his/her account.

B. Commercial Paper - short-term, unsecured promissory notes (IOUs) issued by large firms with
great financial strength and high credit rating to other companies and institutional investors,
such as trust funds, banks, and insurance companies. Commercial papers entail lower cost
than bank financing (the interest rate is usually lower that the prime rate* and the costly
financial arrangements are avoided). One disadvantage, however, is their limited access and
availability. Only the largest firms with the greatest financial strength can issue commercial
papers. The amount of funds available is limited to the excess liquidity of big corporations.
* Prime Interest Rate - the rate charged by commercial banks to their best business clients. - It
is usually the lowest rate charged by banks.
Cost of Commercial Paper
Effective Annual = Interest Cost per period x Number of days in a year
Interest Rate Usable Loan Amount Number of days funds are borrowed
Example: Giant Corporation plans to issue P500M in commercial paper for 180 days at a
stated, discounted interest rate of 10%. Dealers of the commercial paper usually charge
P200, 000 in placement fees and flotation costs. (Use 360 days in a year)

Effective Annual Interest Rate = P25M* x 360 = 10.53%


P500M – P25M –P200, 000 180
* Interest Cost per period – P500M x 10% x 180/360 = P25M

Secured Short-Term Credit


A. Aging of Receivables - a certain peso amount of receivables is provided by the borrowers
as
collateral for a short-term loan.
B. Pledging of Inventories - part or all of the borrower's inventories are provided by the
borrowers as collateral for a short-term loan
 Classifications of Inventory Loans:
1. Floating Lien - the creditor (lender) has a general claim on all of the borrower's
inventory. The lender acquires title to the inventory and the borrower cannot
control its size or disposition.
2. Trust Receipt - the lender holds title to specific Units of inventory pledged which are
identified in writing on documents called trust receipts.
1. Warehouse Receipt - the inventory pledged is placed under the lender's physical
and legal possession. The pledged inventory is stored in a public warehouse
controlled by the warehousing company. The inventory is released to the
borrower only when such release is authorized by the lender.
C. Other Sources of Short-term funds
1. Factoring of Accounts Receivables
A factor buys the accounts receivable of a firm and assumes the risk of collection.
2. Banker's Acceptances
Often used by importers and exporters, these are drafts drawn by a non-financial
firm on deposits at a bank. The bank's acceptance is a guarantee of payment at maturity.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes

Long-Term Financing Decisions

I. Capital Structure - the mix of the long-term sources of funds used by the firm. (This is different from
FINANCIAL STRUCTURE which is the mix of all the firm's assets.)

Objective: to maximize the market value of the firm through an appropriate mix of long-term sources of
funds.

Composition: Long-term debt, Preferred stock, Common stockholders' equity

Capital Structure = Financial Structure - Current Liabilities


Optimal Capital Structure - mix of long-term sources of funds that will minimize the firm's overall cost of
capital

Cost of Capital - the cost of using funds; it is also called hurdle rate, required rate of return, cut-off rate. It
is the weighted average rate of return the company must pay to its long-term creditors and shareholders
for the use of their funds.
Computation of Cost of Capital
Source Capital Cost of Capital
Creditors Long-term debt After-tax rate of interest i (1 - TxR)
Stockholders:
Preferred dividends per share
Preferred Preferred stock
Current market price or Net issuance price
Earnings per share
Common Common stock
Market price per share

Other Ways of Computing Cost of Capital


1.Capital Asset Pricing Model (CAPM)
R = RF β (RM - RF)
Where: R = rate of return (or cost of capital)
RF = risk-free rate determined by government securities
β = beta coefficient of an individual stock which is the correlation between the volatility
(price variation) of the stock market and the volatility of the price of the individual stock
Example: If the price of an individual stock rises 10% and the stock market 15%, the beta
is 1.5.
RM = market return
(RM - RF) = market risk premium or the amount above risk-free rate required to induce
average investors to enter the market
Example: Assume a beta of 1.5, a market rate of return of approximately 16% and an expected risk-free
rate of 12%, what is the R?
R = RF β (RM - RF)
= 12% + 1.5(16% - 12%) = 18%
2. Dividend Growth Model
a. Cost of Retained Earnings = D1
+G
P0
Where: P0 = current price
P1 = next dividend
G = growth rate in dividends per share (it is assumed that the dividend
Payout ratio, retention rate, and therefore the EPS growth rate
are constant)
Example: A company's dividend is expected to be P5 while the market price is P60 and the
dividend is expected to grow at a constant rate of 10%, the cost of retained earnings is:
5/60 + 10% = 18.33
b. Cost of New Common Stock = D1
P0 (1- Flotation cost)
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes

Flotation Cost = the cost of issuing new securities


Factors Influencing Capital Structure Decision
1. Business Risk - uncertainty inherent in projections of future returns on assets.
 THE GREATER THE BUSINESS RISK, THE LESS DEBT SHOULD BE INCLUDED IN THE
CAPITAL STRUCTURE.
2. Tax Position - generally, the higher the firm's tax rate, the more debt it should include in its capital
structure. Reason: interest is tax deductible
3. Financial Flexibility - refers to the firm's ability to raise capital on reasonable terms even under
adverse conditions.
4. Managerial Aggressiveness - refers to some financial managers inclination to use more debt to
boost profit LEVERAGE- refers to that portion of the fixed costs which represents a risk to the firm

Leverage
1. Operating Leverage - (a measure of operating risk) refers to the fixed operating costs found in
the firm's income statement
 THE HIGHER THE FIRM'S OPERATING LEVERAGE, THE HIGHER ITS BUSINESS RISK,
AND THE LOWER ITS OPTIMAL DEBT RATIO
Degree of Operating Leverage (DOL) = CM
EBIT
2. Financial Leverage - (a measure of financial risk) refers to financing a portion of the firm's
assets, bearing financing charges in hopes of increasing the return to the common
stockholders.
 THE HIGHER THE FINANCIAL LEVERAGE, THE HIGHER THE FINANCIAL RISK, AND
THE HIGHER THE COST OF CAPITAL

Degree of Financial Leverage (DFL) = CM


EBIT- Interest
3. Total Leverage - the measure of total risk
 A DECREASE IN OPERATING LEVERAGE WOULD CAUSE AN INCREASE IN OPTIMAL
AMOUNT OF FINANCIAL LEVERAGE.
 .A DECREASE IN OPERATING LEVERAGE WOULD RESULT INTO A DECREASE IN
THE OPTIMAL AMOUNT OF DEBT
Degree of Total Leverage (DTL) =DOL x DFL or CM
EBIT- Interest

VIII. Sources of Long-term Financing

Principal Sources of Funds


1. External Sources: Debt, Equity, and Hybrid Financing
2. Internal Sources: Operations

A. Debt Financing
Advantages:
1. Basic control of the firm is not shared with the creditor.
2. Cost of debt is limited. Creditors usually do not participate in the superior earnings of
the firm.
3. Interest paid is tax deductible, thereby reducing cost of capital.
4. Substantial flexibility in the financial structure is enhanced by debt through the
inclusion of call provisions in the bond indenture.
5. The financial obligations are clearly specified and of a fixed nature.
6. In time of inflation, debt may be paid back with "cheaper pesos".

Disadvantages:
1. Since debt requires a fixed charge, there is a risk of not meeting this obligation if the
earnings of the firm fluctuate.
2. Debt adds risk to t. firm.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes

3. Debt usually has a maturity date.


4. Debt is a long-term commitment, a factor that can affect risk profiles.
5. Certain managerial prerogatives are usually given up in the contractual relationship
outlined, in the bond's indenture contract. Example: specific ratios must be kept
above a certain level during the term of the loan.
6. There are clear-cut limits to the amount of debt available to the individual firm.

Basic Types of Bonds or Long-term Debt


1. Debenture Bonds - unsecured loan; these can be issued only by companies with the
best credit ratings.
2. Mortgage Bonds - a pledge of certain assets, such as real property, for a loan.
3. Income Bonds - pay interest only if the issuing company has earnings; these bonds are
riskier than other bonds.
4. Serial Bonds - bonds with staggered maturities.

B. Equity Financing - major source is common stocks and retained earnings.


Advantages of Common Stock as Source of Funds
1. Common stock does not require a fixed dividend -- dividends are paid from profits
when available.
2. There is no fixed maturity date for repayment of the capital.
3. The sale of common stock is frequently more attractive to investors than debt,
because it grows in value with the success of the firm.
• THE HIGHER THE COMMON STOCK VALUE, THE MORE ADVANTAGEOUS
EQUITY FINANCING IS OVER DEBT FINANCING.

Disadvantages of Common Stock as source of Funds:


1. As more shares are sold, the stockholders'' control (voting rights) and share in
earnings are usually diluted.
2. Issuance of common stocks requires higher underwriting costs.
3. Common stock cash dividends are not tax deductible.
4. The average cost of capital may increase above the optimal level when too much
equity is issued.

IX. Retained Earnings


Earnings after deducting interest, taxes, and preferred dividends may be retained and used to pay
common cash dividends or be plowed back into the firm in the form of additional capital investment
through stock dividends.
Advantages
1. The after-tax opportunity cost is lower than that for newly issued common stock.
2. Financing with retained earnings leaves the present control structure intact.

C. Hybrid Financing - sources of funds that possess a combination of features; these include preferred
stock, leasing, and option securities such as warrants and convertibles.
 Preferred Stock - a hybrid security because some of its characteristics are similar to those of both
common stocks and bonds. Legally, like common stock, it represents a part of ownership or
equity in a firm. However, as in bonds, it has only a limited claim on a firm's earnings and
assets.
Features of Preferred Stock Issues
a. Priority to assets and earnings - the claims of preferred stockholders must first be
satisfied before the cor,,mon stockholders receive anything.
b. Preferred stocks al' .,.ys have par value, which is important in determining the
amount due to Preferred Stockholders in case of liquidation and in computing the
preferred dividends.
c. Most preferred stocks provide for cumulative dividends.
d. Some preferred stock issues are convertible to common stocks.
Lecture 7 - Working Capital Management
Assistant Professor Ronaldo C. Reyes

Advantages and Disadvantages of Issuing Preferred Stocks:


Advantages
1. No default risk because non-payment of
dividends does not necessarily mean Disadvantages
bankruptcy.
1. Preferred dividends are not tax deductible;
2. Dividend payment is limited to stated amount. hence, cost for the company is higher than
3. No voting rights like common stocks, except that of bonds.
in the case of financial distress 2. The cumulative feature of preferred stock
4. Call features and provision of sinking fund makes payment of preferred dividends
may be included, so the firm may replace almost mandatory
the issue if interest rates decline

 Lease Financing
Lease - a rental agreement that typically requires a series of fixed payments that extend over
several periods.
Leasing vs. Borrowing - leasing represents an alternative to borrowing. The lease payments are
very similar to loan amortization, with part of payment applied to principal, and part to interest. Like
loan agreements, lease contracts usually contain restrictive covenants like the requirement to
maintain minimum debt-equity ratios or minimum level of liquid assets.
• Basic difference of leasing from debt: ownership of the asset Leasing Benefits
1. Increased Flexibility - in some cases, lease can be cancelled or replaced with a new one,
depending on the need of the firm.
2. Certain maintenance at a known cost
3. Lower administrative costs - a company may just let some other party to take care of its assets
instead of creating a new department to take care of the acquisition, maintenance, and
eventual sale of the asset.
4. The tax shield generated by lease payments usually exceeds that from depreciation if the
asset were purchased.
Types of Leases
1. Operating Lease - usually short-term and often cancelable; obligation is not shown on the
balance sheet; maintenance and upkeep of asset is provided by the lessor;
lease payment is treated as rent expense.
2. Financial or Capital Lease - non-cancelable, longer-term lease that fully amortizes the
lessor's cost of the asset; service and maintenance are usually provided by the
lessee.
3. Sale-Leaseback Arrangement - assets that are already owned by a firm are
purchased by a lessor and leased back to the firm.
4. Direct Leases - identical to the sale-leaseback arrangement, except that the
lessee does not necessarily own the leased asset; the lessor already owns or
acquires the asset, which is then provided to the lessee.
5. Leveraged Leases - a special lease arrangement under which the lessor borrows
a substantial portion of the acquisition cost of the leased asset from a third party.
> CONVERTIBLE SECURITIES - preferred stock or debt issue that can be exchanged for a
specified number of shares of common stock at the will of the owner. These are
considered hybrid securities because they provide the stable income associated
with preferred stock and bonds in addition to the possibility of capital gains
associated with common stocks.
Advantages and Disadvantages of Issuing Convertible Securities:

Advantages selling common stock at higher than market


price at the time the convertible is issued.
1. By giving investors an opportunity to
realize capital gains, a firm can sell debt 2. If the firm's stock price rises sharply, it would
with a lower interest rate. have been better off if it waited and sold the
common shares at a higher price.
1. Convertibles provide a way of selling
common stock at prices higher than
those currently prevailing.

Disadvantages
1. Sale of convertibles may be thought of as
Working Capital Management
Assistant Professor Ronaldo C. Reyes

OPTION - created by outsiders rather than the firm itself, it is a contract that gives its holders the right to
buy (or sell) stocks at some predetermined price within a specified period of time.
WARRANT - an option granted by the corporation to purchase a specified number of shares of common
stock at a stated price exercisable until some time in the future called the expiration date. It is a
company-issued call option. Often, it is attached to debt instruments as an incentive for
investors to buy the combined issue at a lower interest rate.

***************The End***************

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